Dereliction of the Big Four blamed for financial crisis

As with most man-made catastrophes, the financial crisis had multiple
different causes which were then compounded by a bungled policy response.

If you were looking for evidence of a flawed, high-risk business model, there it all was in Northern Rock's published accounts for 2006. Unfortunately, most of those who took the trouble to read them saw these risks not as weaknesses but as competitive strengths. Such is the wisdom of hindsight.

But of all those who might legitimately be blamed, you might have thought the "Big Four" audit practices come some way down the list.

Not according to the House of Lords Economic Affairs Committee, which places them firmly in the dock alongside regulators, credit-rating agencies and the financiers themselves. In a hard-hitting report which calls for a full competition inquiry into this supposedly seriously flawed oligopoly, the audit firms are accused not just of "complacency" but "a dereliction of duty".

Is this fair? There are important lessons for the accounting profession from the financial crisis, and it is obviously the case that for multi-national audit to be dominated by just four firms – actually, only three when it comes to UK banks – is an unacceptable state of affairs.

Were these three guilty of complacency? Judging by their attitude in giving evidence to the Committee, that's for sure. Should dialogue between auditors and regulators be made mandatory? Absolutely. Does the perverse way in which international accounting standards managed to exaggerate the profits of the boom and compound the losses of the bust need re-examining? Most certainly. But does all this add up to a "dereliction of duty"? Well, that seems harsh given that as yet there has been no evidence to suggest audit failure as even a minor contributory cause of the crisis. To the contrary, virtually all official reports to date have cleared the profession of that charge. Nobody, other than compensation-chasing litigants, has said audited accounts in the run up to the crisis failed to give a true and fair view.

If you were looking for evidence of a flawed, high-risk business model, there it all was in Northern Rock's published accounts for 2006. Unfortunately, most of those who took the trouble to read them saw these risks not as weaknesses but as competitive strengths. Such is the wisdom of hindsight.

To believe that auditors should be assessing the safety of the business model, or should be determining the correct level of regulatory capital, is to misunderstand the parameters and purpose of audited accounts. These judgments are for investors and regulators to make. The auditor is just the messenger.

Auditing performs the vital purpose of ensuring the reliability and transparency of published accounts, and is therefore fundamental to the integrity of the capital markets.

But was PwC derelict in its duties in failing to say of the Northern Rock accounts: "Blimey, if the wholesale money markets freeze up, this bank is well and truly stuffed"? That's never really been part of the auditor's function. As Sir Michael Rake, a former head of KPMG and now chairman of BT Group, puts it: "The auditor is the long stop on the cricket pitch, not the slip."

Yet there is also a sense in which the House of Lords is right in highlighting a progressive abdication by auditors of wider prudential responsibilities. Hand in hand with a spectacular improvement in the quality and quantity of information that published accounts give to investors and creditors, there has been a narrowing down of these more intangible but once highly valued functions.

Auditors have been backed into an ever more tightly defined space by a combination of box-ticking regulation, rules-based accounting standards and aggressive litigation, and they dare not stray beyond it.

In the context of accounting, three examples of Hutber's Law ("improvement means deterioration") stick out from the banking crisis like a sore thumb. One is the abolition under accounting rules of "general provisions", this on the grounds that any provision which doesn't apply to a specific bad debt was both misleading to investors and by depressing profits, potentially disadvantageous to the taxman.

In fact, squirrelling money away for a rainy day is for a bank not just a part of sensible housekeeping but also performs a vital counter-cyclical purpose. Post the banking crisis, these old-fashioned practices have been recognised as so self-evidently a good thing they are now being brought back under the guise of "macro-prudential" regulation.

Then there was the removal of the mandatory obligation on auditors to meet with regulators to discuss matters of concern. This didn't entirely disappear under the rule of the Financial Services Authority, but like much prudential oversight, it fell into a state of disrepair.

Finally, there was the introduction of "mark to market" or "fair value" accounting, one of those initiatives that seemed a fine idea in principle but in practice turned out to be an unmitigated disaster.

Debt, the stuff in trade of banking, is by definition not meant to be volatile. A loan is a loan, whether held to maturity, paid back early or in default. But once it becomes a tradable asset, it can go up and down, much like shares.

During the boom, banks happily booked the profits from the appreciating "market value" of their asset base – and realised big bonuses on the back of it. But then came the bust and the whole process went into reverse, wiping out wafer-thin capital buffers and causing depositors to run for the hills. As we are now discovering, many of these supposed losses are as illusory as the profits. The actual default rate is smaller than assumed in the depths of the crisis.

As for the dominance of the Big Four, there's no real conspiracy against the public here either. Regulators failed to stop the merger of Price Waterhouse and Coopers, as they should have done, while the judicial garrotting of Andersen in the wake of the Enron collapse, further reducing six firms to just four, also turned out to an entirely unnecessary act of self-inflicted vandalism. Andersen was eventually cleared of the charge, but by then it was too late; the firm had disappeared.

I won't quarrel with any of the report's recommendations, which are all perfectly sensible, but there is something wearily familiar about it all. In every economic downturn, the cry goes up: "Why didn't the auditors see this coming and blow the whistle?"

Well, maybe that function should be made more explicit, but if it is, then it will transform the role of the auditor from the fair presentation of accounts into a part of the supervisory process. That's quite a leap.